Financial instruments – IBOR reform with accounting consequences under German GAAP and IFRS
The background to the reform
On international financial markets, reference rates such as LIBOR (London Interbank Offered Rate) and EURIBOR (Euro Interbank Offered Rate) play a major role in transactions between different banks. Loans, derivatives, securities and bank deposits with a variable interest rate component are usually aligned with the current fluctuating reference rate.
As these benchmark interest rates are considered to be vulnerable to manipulation and also to be non-transparent it was decided, on the basis the the EU Benchmarks Regulation (BMR) of 2016, that these types of benchmark interest rates should be superseded by replacements that are transparent and less vulnerable to manipulation, so-called risk-free rates – RFRs – or else alternative reference rates – ARRs.
This reform is admittedly not about implementing new interest rates but rather about developing a more transparent method for calculating reference rates. This may however then have implications for the recognition of financial assets under German GAAP and IFRS if no new reference rate has been contractually agreed for the respective financial asset as at the reporting date. The standard setters have responded to this accordingly.
Adjustments to IFRS policies
The IASB divided the effects of the changes to reference rates on accounting into two phases. In the first phase, from September 2019, accounting issues were addressed that existed in the run-up to the replacement (e.g., recognition of hedging relationships). The second phase concerns issues arising at the time when a reference rate is replaced.
To this end, on 13.1.2021, the European Union published a Commission Regulation that endorsed the amendments to IAS 39, IFRS 9 and IFRS 7; these amendments became effective for financial years beginning on 1.1.2021. In addition, IFRS 4 and IFRS 16 were adjusted in relation to financial assets, financial liabilities and lease liabilities.
The aim of these amendments is to make it possible for hedging relationships to continue despite the current uncertainties regarding the reform of reference rates. Accordingly, the amendments to the policy apply only for hedging relationships that are directly affected by a switch in the reference rate as well as for the reversal of cash flow hedge reserves, in order to avoid recycling to the profit and loss account.
In this connection, the IASB has issued an exemption, for a restricted time period, according to which a company may assume that the ‘highly probable’ criterion under IFRS 9 and IAS 39 will also apply for cash flow hedges where the reference rate will be replaced with an alternative reference rate. This will then be the case if the future hedged cash flows are ‘highly probable’.
If there has not yet been a contractual adjustment for the respective hedging relationship where there is a new underlying reference rate then, as a result of the switch in the reference rate in a hedging relationship, there could be difficulties with the retrospective assessment under IAS 39. Such difficulties may arise when it can no longer be demonstrated that the effectiveness of the hedging relationship falls within the 80% to 125% range. This condition under IAS 39 has been suspended by the IASB – because of the associated uncertainty for the affected hedging relationships – until the uncertainty has been eliminated through adjustments to contracts.
If a change in the reference rate results in changed contractual cash flows then the carrying amount of the affected financial instrument should not be adjusted or derecognised but instead the effective interest rate should be updated. This would mean that a profit or a loss would not have to be immediately recorded. This relief applies only for changes that are a direct result of the IBOR reform.
Adjustments under German GAAP
The changes associated with IBOR reform to the preparation of financial statements in accordance with German GAAP (also referred to as the Commercial Code, Handelsgesetzbuch, HGB) relate to floating rate financial instruments, free-standing derivatives and hedging relationships in accordance with Section 254 HGB.
Reference rates are an essential feature of floating rate financial instruments. Insofar as their other essential features remain unchanged then there will be no change in their nature as floating rate financial instruments. In addition, the change in the reference rate leaves the legal and economic ownership of the floating rate financial instrument unchanged with the reporting entity, whereby ultimately no change in the recognition of floating rate financial instruments arises.
According to the principles for pending transactions, free-standing derivatives that are not recognised as a hedging relationship as defined in Section 254 HGB, generally, only have to be recognised if there is a risk that they will be a source of losses. However, a change in the reference rate to which the variable side of a derivative is tied will have no effect on the recognition of provisions for anticipated losses.
According to Accounting Standard 35 of the Auditing and Accounting Board (Hauptfachausschuss, HFA) of the Institute of Public Auditors in Germany (Institut der Wirtschaftsprüfer, IDW) – (IDW RS HFA 35) –, hedging relationships have to be dissolved if the hedged item and/or the hedging instrument are no longer recognised. A change in the reference rate does not result in a due date for or the derecognition of the hedged item and/or the hedging instrument. There are likewise no effects on the intention to hedge that arise from a change in the reference rate. Consequently, the hedging relationship will be maintained even after a change in the reference rate.
Implications for the disclosures in the notes to the financial statements
The following information will have to be provided for each reference rate that is relevant for a company:
- type and extent of risks in the context of the IBOR reform,
- company’s progress with respect to the transition to alternative reference rates and
- description of the process for transitioning to the new reference rates.
Companies will be expected to provide quantitative data for hedging instruments where the switchover to a new reference rate is still outstanding. These should be disclosed separately according to:
- non-derivative financial assets,
- non-derivative financial liabilities,
- derivative instruments
If the change in the reference rate gives rise to any settlement payments then deferred expenses have to be recognised for these payments in accordance with Section 250 HGB and explained in the notes to the financial statements.
IBOR reform has increased documentation and procedural requirements for companies that hold financial instruments that are linked to reference rates. These will have to be examined on a company-specific basis.
It has been possible to stave off the undesirable effects of the IBOR reform on financial accounting by adjusting the regulatory basis. As a result of these adjustments it will be possible to take make the appropriate allowances for any accounting consequences and to evaluate them precisely beforehand.
Outlook: EURIBOR will also potentially be replaced by 2025 already. This will then likewise be a relevant issue for financial products that have hitherto been based on EURIBOR.